To say that most small to midsize businesses have at least considered taking out a loan this year would probably be an understatement. The economic impact of the COVID-19 pandemic has lowered many companies’ revenue but may have also opened opportunities for others to expand or pivot into more profitable areas.
If your company needs working capital to grow, rather than simply survive, you might want to consider a mezzanine loan. These arrangements offer relatively quick access to substantial funding but with risks that you should fully understand before signing on the dotted line.
Equity on the table
Mezzanine financing works by layering a junior loan on top of a senior (or primary) loan. It combines aspects of senior secured debt from a bank and equity-based financing obtained from direct investors. Sources of mezzanine financing can include private equity groups, mutual funds, insurance companies and buyout firms.
Unlike bank loans, mezzanine debt typically is unsecured by the borrower’s assets or has liens subordinate to other lenders. So, the cost of obtaining financing is higher than that of a senior loan.
However, the cost generally is lower than what’s required to acquire funding purely from equity investment. Yet most mezzanine instruments do enable the lender to participate in the borrowing company’s success — or failure. Generally, the lower your interest rate, the more equity you must offer.
Flexibility at a price
The primary advantage of mezzanine financing is that it can provide capital when you can’t obtain it elsewhere or can’t qualify for the amount you’re looking for. That’s why it’s often referred to as a “bridge” to undertaking ambitious objectives such as a business acquisition or desirable piece of commercial property. But mezzanine loans aren’t necessarily an option of last resort; many companies prefer their flexibility when it comes to negotiating terms.
Naturally, there are drawbacks to consider. In addition to having higher interest rates, mezzanine financing carries with it several other potential disadvantages. Loan covenants can be restrictive. And though some lenders are relatively hands-off, they may retain the right to a significant say in company operations — particularly if you don’t repay the loan in a timely manner.
If you default on the loan, the lender may either sell its stake in your company or transfer that equity to another entity. This means you could suddenly find yourself with a co-owner who you’ve never met or intended to work with.
Mezzanine financing can also make an M&A deal more complicated. It introduces an extra interested party to the negotiation table and can make an already tricky deal that much harder.
Explore all options
Generally, mezzanine loans are best suited for businesses with clear and even aggressive growth plans. Our firm can help you fully explore the tax, financial and strategic implications of any lending arrangement, so you can make the right decision.
© 2020 Covenant CPA
Sometimes estates that are large enough for estate taxes to be a concern are asset rich but cash poor, without the liquidity needed to pay those taxes. An intrafamily loan is one option. While a life insurance policy can be used to cover taxes and other estate expenses, a benefit of using an intrafamily loan is that, if it’s properly structured, the estate can deduct the full amount of interest upfront. Doing so reduces the estate’s size and, thus, its estate tax liability.
Deducting the interest
An estate can deduct interest if it’s a permitted expense under local probate law, actually and necessarily incurred in the administration of the estate, ascertainable with reasonable certainty, and will be paid. Under probate law in most jurisdictions, interest is a permitted expense. And, generally, interest on a loan used to avoid a forced sale or liquidation is considered “actually and necessarily incurred.”
To ensure that interest is “ascertainable with reasonable certainty,” the loan terms shouldn’t allow prepayment and should provide that, in the event of default, all interest for the remainder of the loan’s term will be accelerated. Without these provisions, the IRS or a court would likely conclude that future interest isn’t ascertainable with reasonable certainty and would disallow the upfront deduction. Instead, the estate would deduct interest as it’s accrued and recalculate its estate tax liability in future years.
The requirement that interest “will be paid” generally isn’t an issue, unless there’s some reason to believe that the estate won’t be able to generate sufficient income to cover the interest payments.
Ensuring the loan is bona fide
For the interest to be deductible, the loan also must be bona fide. A loan from a bank or other financial institution shouldn’t have any trouble meeting this standard.
But if the loan is from a related party, such as a family-controlled trust or corporation, the IRS may question whether the transaction is bona fide. So the parties should take steps to demonstrate that the transaction is a true loan.
Among other things, they should:
- Set a reasonable interest rate (based on current IRS rates),
- Execute a promissory note,
- Provide for collateral or other security to ensure the loan is repaid,
- Pay the interest payments in a timely manner, and
- Otherwise treat the loan as an arm’s-length transaction.
It’s critical that the loan’s terms be reasonable and that the parties be able to demonstrate a “genuine intention to create a debt with a reasonable expectation of repayment.”
If you’re considering making an intrafamily loan, contact us at 205-345-9898. We’d be pleased to answer any questions you may have.
© 2018 Covenant CPA